Russell Investments, known for its Russell 2000 index of small stocks, has earned a reputation for financial savvy and smart money management. Then it went into the hedge-fund business.

The result was a misadventure that has lost Russell and its investors lots of money, and led to a partial retreat from hedge funds. At issue are its funds of funds - umbrella holdings that channel investments into collections of hedge funds. Russell, a unit of insurer Northwestern Mutual, set them up over the past seven years to get in on a lucrative trend.

Now, partly as their performance has slipped and investors have run for the exits, it is winding down three of them. Meanwhile, Russell has suffered a raft of high-level management departures, including its chief executive. It said many of the moves are unrelated to the hedge-fund problems.

Russell traditionally has stuck to more prosaic areas such as running mutual funds or advising pensions and endowments on where to place investments. The firm's woes point to the perils of expanding beyond a core business into the more-lucrative but treacherous field of alternative investments, such as hedge funds.

The funds Russell is closing, which focused on institutional investors, are gradually returning principal to clients, although when all the money will be reimbursed is unclear. The funds of funds' assets shrank to less than $2bn (€1.36bn) from $6bn since last year.

Shutting down are seven-year-old Russell alternative strategies fund, which had $3bn in assets as of mid-2007, and four-year-old Russell alternative strategies fund II, with $2.2bn. The firm also is winding down Russell diversified alternatives fund, which began in 2003 and had $622m as of last summer.

That will leave Russell with one small fund of funds - the $101m Russell global directional strategies, which made its debut last year - and offerings in areas such as mutual funds, real estate and private equity.

Russell, of Tacoma, Washington, said it still is trying to find out what went wrong with the hedge-fund business. Russell insists it remains committed to alternative investing. Boston Consulting Group, in a recent review of Russell's strategy, suggested it keep focusing on alternative investing, because it is an expanding business worldwide. "We expect to eventually be back in the hedge-fund space," said Russell's interim chief executive, John Schlifske.

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Moving into the hedge-fund business seemed to be a natural for Russell, which would use its expertise picking more traditional investment managers to help clients pick hedge funds. Russell's closed funds of funds put money into 30 to 40 hedge funds each, investing for some in such things as US and European distressed debt, asset-backed securities and quantitative strategies. Many had strong positions tied to mortgage-backed securities.

More trouble came in recent days, when Greenwich, Conneticut, hedge-fund firm SageCrest , which managed more than $200m for Russell, filed for Chapter 11 bankruptcy protection. SageCrest specialised in asset-based lending to real-estate companies and other ventures. Last year Russell cited a 55% write-down of the SageCrest portfolio as hurting certain fund performance.

Russell's funds of funds allowed easy departures for investors, letting them withdraw each month; many funds of funds limit redemptions to a quarterly basis. When Russell alternative strategies posted a 4.8% loss after fees for 2007, many clients started to bail out.

As a stopgap measure, Russell in February waived its management and performance fees for clients in its two Russell alternative strategies funds. Those fees were about 1.5% of assets yearly for managing the money and somewhat under 20% of any profits.

Russell also imposed, for the first time, restrictions on investor withdrawals earlier this year. At some funds of funds, Russell said, redemptions are capped at only 10% and Russell imposed a similar restriction earlier this year, but recently paid out around 40% of the remaining holdings to clients.

A disagreement about the redemption rules was one reason David Tsujimoto, Russell's head of hedge funds, left last year to join another money manager, according to a person familiar with the matter.

The winding down of $6bn in these funds of funds represents a small fraction of Russell's $211bn in assets. While parent Northwestern Mutual doesn't provide detail on Russell's financial contributions, the insurer, which has $157bn in assets, said it is an important unit.

-- Write to Diya Gullapalli at diya.gullapalli@wsj.com and Craig Karmin at craig.karmin@wsj.com